Modifying Trusts to Achieve Tax Objectives

Take-Away: The terms of an irrevocable Trust can be modified by a probate court to reflect the settlor’s probable intent regarding tax objectives. However, there is also the limitation of the need for the state’s highest court to rule on that modification.

Background: Most of us are aware that the Michigan Trust Code (MTC) contains several provisions that enable a probate court to modify the terms of an irrevocable Trust. Some of those statutes have been summarized in prior missives. One that has not yet been covered is the MTC section that permits a probate court to modify the terms of an irrevocable Trust to achieve the settlor’s tax objectives.

MCL 700.7416: This very short statute is taken straight from the Uniform Trust Code (UTC).

“To achieve the settlor’s tax objectives, the court may modify the terms of the trust in a manner that is not contrary to the settlor’s probable intention. The court may provide that the modification has retroactive effect.”

MCL 700.7416 thus by statute, approves tax minimization as a legitimate estate planning objective, which is consistent with Michigan’s public policy. It is one of the few MTC sections that cannot be overridden by the terms of the Trust. [MCL 700.7105(2)(d).]

Precedent: At present there does not appear to be any reported Michigan court case where a probate court has relied on this statutory authority to modify the terms of a Trust to achieve the settlor’s probable intention regarding tax consequences to the Trust the settlor created. However, there are several cases in other jurisdictions that have adopted the UTC where this section has been relied upon by a court to modify the terms of an irrevocable Trust.

Tax Objectives: The most common situations where this authority to modify the terms of a Trust for tax reasons is used are: (i) to minimize the generation skipping transfer tax (GST), which is a common objective in long-term Trusts; and (ii) altering a fixed dollar amount used in a Trust instrument, when the tax laws now use statutory inflation adjustments, e.g., reference to the annual exclusion amount expressed as a withdrawal right, where the amount subject to the withdrawal right changes due to inflation. A brief summary of some other reported cases where the terms of the trust were modified, or reformed, for tax reasons include:

Omitted Tax-Sensitive Provisions: To correct Trust instruments that were improperly drafted, e.g. “as the settlor clearly intended to create a trust that qualified for the marital deduction so it can only be scrivener’s error that omitted a clause that would have provided income to be paid to the surviving spouse for life after the settlor’s death..”

Preserve a Marital Deduction: To obtain the marital deduction by creating a qualifying income interest for the surviving spouse for life.

Apportion Taxes: To achieve an equitable apportionment or otherwise alter how transfer taxes are apportioned among beneficiaries, usually to absolve a marital deduction of the tax burden or to maximize a charitable estate tax deduction.

Accelerate a CRT: To bestow a power to assign a lead beneficiary’s interest in a charitable remainder trust (CRT) to the remainder charitable beneficiary.

Impose Ascertainable Standard: To impose an ascertainable standard to limit an individual trustee’s discretion to avoid an unintended IRC 2041 general power of appointment inclusion of trust assets in that individual trustee’s gross estate at death.

Preserve CRT Tax Deduction: To accelerate distribution of a portion of a charitable remainder trust (CRT) to cause the balance of the Trust to meet the 5% minimum annual annuity distribution requirement.

NiCRUT: To add a net income limitation to a charitable remainder unitrust.

Limit Powers of Appointment: To convert taxable general powers of appointment into limited powers of appointment to avoid estate taxes.

Limit Amendment Powers: To limit an amendment provision to preclude a general powers of appointment treatment of the power, i.e., estate inclusion, resulting from the power to amend the Trust.

Fix Crummey Rights: To alter the amount subject to lapsing annual powers of withdrawal to the IRC 2514(e) ‘five-or-five’ safe-harbor amount, or to take advantage of the IRC 2503 gift tax annual exclusion, e.g., the beneficiary’s annual withdrawal right was increased to reflect the increase in the annual exclusion amount, but the court then refused to add to the Trust a hanging withdrawal power conferred on the trust beneficiaries.

Remove Retained Powers: To remove powers retained by the settlor to reduce the settlor’s estate’s exposure to IRC 2036(a)(2) estate inclusion.

QPRT Reversions: To account for unanticipated contingencies, e.g., a QPRT was reformed to provide a reversion to the QPRT settlor if his death occurred during the settlor’s fixed exclusive use term; and

State Transfer Taxes: To adapt to changes in a state’s inheritance or estate tax laws.

Limitations: Despite this statutory authority to modify the terms of an irrevocable Trust to achieve the settlor’s probable tax objectives, there are some inherent limitations.

Dispositive Scheme: There are a handful of reported court cases where the court limited this authority of trust modification for tax reasons to not alter the original dispositive provisions of the Trust. In one case, In re Tr. D. Created Under Last Will and Testament of Darby, 234 P.3d 793 (Kan. 2010) the court held that ‘modification of trust provisions to achieve tax benefits cannot be validated when it would alter the dispositive provisions of the trust.”   While in In re Estate of Branigan, 609 A.2d 431 (N.J. 1992,) the court said “We cannot conclude that plaintiffs’ desire to evade taxes at the cost of the dispository scheme and the possible disinheritance of some of the heirs effectuates the testamentary intent of the testator.”

Federal Government: Perhaps the even larger unresolved issue is whether a trust modification for tax reasons will be binding on the IRS. In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967) the Supreme Court held that federal courts should not completely disregard decisions of a lower state court when ascertaining principles of state law for the purpose of interpreting federal tax law. However, only decisions of a state’s highest court are binding on the IRS.

In response to Bosch, some state supreme courts have granted appellate review expressly for the purpose of affirming lower state court decisions to render the decision binding on federal authorities, e.g., ‘friendly’ appeals solely for this ‘tax-fix’ purpose.   In re St. Clair Trust Reformation, 464 P.3d 326 (Kan. 2020)  a Trust was reformed for tax purposes, by misstating the tax consequences, in order add a beneficiary’s  5+5 withdrawal power in the settlor’s husband’s Trust, in order to preclude the ‘reciprocal trust doctrine’ for Trusts simultaneously created by the spouses, which was appealed to the Kansas Supreme Court solely to have the state’s highest court render an ‘interpretation.’

In a couple of Private Letter Rulings [PLR 201243001 and PLR 200848009] the IRS refused to honor decisions of a lower state court that were incorrectly decided or not supported by the evidence. The point being, since Bosch remains binding law, it might be wise to heed the Bosch requirement, all of which may be why there are, as of this time, no reported cases in Michigan which rely on MCL 700.7416.

Conclusion: As the tax laws change, or Congress threatens to change them, seemingly yearly, a trustee may respond by seeking modifications of an irrevocable Trust that is administers to realize the benefit of current favorable provisions that might be altered in the future. MCL 700.7416 is a tool that the trustee can use if modification is warranted. However, such a petition for trust modification for tax reasons in the probate court is just the start of a long court-journey if the ultimate goal is for that trust modification to be binding on the IRS.